Geek risk management on Wall Street

Sebastian Mallaby:

One year ago, with spectacular timing, a Wall Streeter named Richard Bookstaber published a book on financial engineering. He called it "A Demon of Our Own Design," and his argument was that a new breed of "quants" -- or "quantitative" number-crunchers like him -- had created a system too complex to be manageable. The risks embedded in swaps and options were understood by only a handful of math geeks, and a miscalculation in one corner of the markets could send shock waves globally. Until a week ago, Bookstaber seemed unduly glum. But in the wake of Bear Stearns, modern financial engineering has become harder to defend.

Bookstaber seemed too pessimistic because he understated the ability of Wall Street players to check and balance one another. Yes, modern finance had an alarming tendency to load debt upon debt, so the effect of a mistake was magnified. But the financial engineers who created these tottering cash towers had an incentive to stop building before the whole thing keeled over. If a bank borrowed too much, lenders would shut off the taps and clients would refuse to buy its swaps, options and synthetic bonds: Nobody wants to do business with a bank that is one shock away from bankruptcy. So financial engineers would certainly take risks. But scrutiny from fellow engineers at other firms would prevent them from overdoing it.

Even a year ago, reasonable people disagreed about whether these checks and balances were sufficient. After all, they failed periodically. A decade ago, a hedge fund named Long-Term Capital Management borrowed so much that it could not withstand the shock of Russia's default, and the Federal Reserve had to organize the fund's fire sale to its bankers. Two decades ago, a fancy new product known as portfolio insurance promised investors protection from a crash. But when the crash came in 1987, the insurance not only failed but also contributed to its severity.

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These markets need the same kind of machinery retail markets have to prevent over leveraging of investments. They need the mechanisms that keep investors from going below zero on their investment no matter how big they are. There needs to be the equivalent of a margin call on these instruments and the geeks need to explain all the risks, because it is not just those investors bearing that risk now.